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Analysis in a chapter of the IMF’s latest World Economic Outlook shows that initially fiscal retrenchment typically has contractionary short-term effects on economic activity, with lower output and higher unemployment.

But it is likely to be beneficial over the longer term. “In particular, lower debt is likely to reduce real interest rates and the burden of interest payments, allowing for future cuts to distortionary taxes,” the authors say. By boosting private investment, this increases output in the long term.

Will it hurt?

In the chapter titled “Will It Hurt? Macroeconomic Effects of Fiscal Consolidation,” the authors find that within two years of cutting the budget deficit by 1 percent of GDP, domestic demand—consumption and investment—is about 1 percent lower, and the unemployment rate is about ⅓ percentage point higher. Because net exports––exports minus imports––tend to rise when budget deficits are cut, the overall impact on GDP is a decline of ½ percent.

A number of factors usually soften the short-term impact of fiscal consolidation. Using a new data set, the authors show that central banks usually cut interest rates and the currency falls in value. This helps cushion the impact on consumption and investment, and boosts exports.

Second, fiscal consolidation is less costly when markets are more concerned about fiscal sustainability. Third, consolidations based on spending cuts are less painful than those based on tax hikes. This is largely because central banks cut interest rates more after spending cuts.

Today’s environment

The findings suggest that in today’s environment, fiscal consolidation is likely to have more negative short-term effects than usual.

In many economies, central banks can only provide a limited monetary stimulus because interest rates are already near zero. Moreover, if many countries adjust simultaneously, the output costs are likely to be greater—since not all countries can reduce the value of their currency and increase net exports at the same time. Fiscal retrenchment is also likely to be more costly for members of a monetary union where scope for a fall in the value of their currency is reduced.

The simulations suggest that the contraction in output may be more than twice as large as the IMF’s baseline estimate when central banks cannot cut interest rates, and when the adjustment is synchronized across all countries. But for economies considered at high risk of sovereign default, short-term negative effects are likely to be smaller.

There are a number of ways to reduce the impact of needed fiscal consolidation on the recovery. Measures that are legislated now but only reduce deficits in the future—when the recovery is more robust—would be particularly helpful. Examples include linking statutory retirement ages to life expectancy and improving the efficiency of entitlement programs.

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